A Stock Rally Built on Financial Reform?

Stocks are rallying today in the wake of very little positive news. So some are clinging to the one piece of news that can be spun. The financial reform bill is good for banks and their profits. Yes, State Street did pre-report good profits. But most banks are projected to have falling profits in the second quarter. The real market moving bank analysis has to do with people making the case that the financial reform bill is so good that this is not only not a loss for banks, but it is a big win. And that seems to be the bet investors are making. Indeed, banks stocks are up 3.5% today, one of the biggest moving sectors in the market’s 275 point rally.

But bank stocks might not be as great a buy as many investors are betting. Indeed, while many of the restrictions of the reform bill are less, well, restrictive than many thought they would be. The rules, many of which have yet to be written, will still cost banks. What’s more, a double dip in the economy won’t help banks much either. So a bet on the banks right now is probably misplaced. Here’s why:

Ever since the financial form bill emerged from committee people have been hailing it as a win for the big banks. They will still mostly get to trade derivatives, having to spin off only the most esoteric parts of that businesses. They will still get to create and invest in hedge funds and private equity funds, though they may have to cut back some of their investments. And while the financial reform bill does prohibit prop. trading, banks are feverishly working to continue to do that too.

One early report contended that the Volcker rule would affect less than 1% of banks’ activities. A Wall Street Journal report indicates that financial firms are reconfiguring dealing desks to evade the Volcker rule. And what are they doing? Moving prop activities on to customer desks, as predicted. And this is all being presented as more innocent than it really is, that banks are “scrambling to find new positions for star proprietary traders”. Help me.

Jon Talbott, who writes the Huffington Post’s The Financial Fix blog, has even itemized the 47 short-comings of the financial reform bill. He finds 44 points to make even before touching on the fact that the financial reform bill does very little to stop the very bad bank practice of funding long-term assets with short term borrowing:

45- Overnight repo market: Nothing done to prevent funding of banks and investment banks with many long term obligations with overnight borrowings. Could mean the start of another possible run on the banks from their overnight lenders similar to what happened in this crisis.

But there’s a big problem with investing in bank stocks based on the weakness of financial reforms. Namely, we still really don’t know how much the financial reform bill will cost banks. Banks will not go penniless because of it. Come on, Wall Street always finds a way to make money. But it is fair to assume bank profitability will go down somewhat. And we won’t really know how much until the real rules are written. For instance, the regulator bill says capital limits need to be set, but it leaves it up to regulators to actually do the setting. And there are plenty of instances of that. Investors, of course, have to jump before the final news. That’s how they make money. Making guesses before the market knows all the information. Yes, much will stay the same on Wall Street. But the bet that nothing will change is probably a bad one.